MacroScan - Boosting a Rising Profit Rate

Corporate results for recent quarters in India point to a rapid growth in profits. Quarter-on-quarter increases in net profits of more than 20 per cent are the norm in recent times. Interestingly, despite this sharp improvement in profitability, the clamour for a reduction in corporate tax rates has only increased. Thus, KPMG international has reportedly released a study recently arguing that India should reduce its corporate tax rate substantially, because countries competing with it to attract foreign direct investment such as China and Singapore are likely to further reduce their already low rates, undermining India’s competitiveness in the area (Refer “High corporate tax can affect FDI inflow: KPMG.”, The Economic Times, 25 July 2007).

"With Hong Kong's corporate tax at 17.5 per cent, Singapore's 20 per cent and Malaysia's 27 per cent, these countries, which are also in the process of developing their economies and with their lower corporate tax rates, can provide stiff competition to India for attracting FDI," KPMG International’s global corporate tax rate survey is quoted as saying. Corporate taxes in India vary from 33.6 per cent for domestic companies to 42 per cent for foreign firms.

Given the wide difference in rates between India and these countries, the cut in rates that would be needed to regain competitiveness can have significant implications for government revenues and expenditures. Moreover, it could trigger competing cuts and set off a race to the bottom that takes the corporate tax rate to exceeding low levels. If recommendations of this kind are accepted by developing countries governments would not have the wherewithal to finance crucial social expenditures or would have to rely heaving on higher indirect taxes such as value added taxes, which being more regressive in nature would only aggravate the inequality that galloping profit rates imply.

This, however, is not a largely Indian or even a developing country phenomenon. Supporting rapidly rising profit rates and shares with tax cuts seems to be a global tendency in today’s neoliberal order. Profit rates have indeed been rising globally, as regulations on capital are being liberalised and labour markets rendered flexible. Thus, in its edition of February 10, 2005, The Economist reported: “According to Merrill Lynch, after-tax profits in America (based on national-accounts data, which is more reliable than firms' reported data) rose from about 5.5% of national income in the early 1990s to more than 9% in 2003. American profit margins are now close to a record. The picture is remarkably similar elsewhere. The share of profits in GDP both in Europe and Japan is close to a 25-year high. Taken as a whole, the share of profits in national income for the G7 rich economies has never been higher, calculates UBS.”

This trend has only continued. A recent study by Luci Ellis and Kathryn Smith (“The global upward trend in the profit share”, Bank for International Settlements Working Paper No. 231) finds that “Profits growth has been strong in many developed economies in recent years, and the profit share – the share of factor income going to capital – has been high compared with historical experience.” In fact, profit shares have trended upwards since as far back as the mid 1980s.

Yet, The Economist noted, President George Bush in his second term had an economic agenda with three goals: “First, convince Americans that the economy is actually doing well. Second, credit all good economic news to the tax cuts. Third, push hard for making the existing tax cuts permanent.” Bush’s predilections were clear in his statement that “There's a mindset in Washington that says, you cut the taxes, we're going to have less money to spend.” In sum, he wanted to believe that tax cuts raise revenues rather than reduce them.

In fact, there is a concerted effort even in the financial media to get governments to use the notion of a “Laffer curve” to justify arguments for substantially reducing taxes on profits. The idea of such a curve with particular characteristics has been used since the mid 1970s to promote tax cuts for the rich, on the ground that this would result in an increase in tax revenues for the government. The curve reflects the view that when tax rates rise, initially revenues gained from such rates would rise, but beyond some maximal point any further increase in taxes would in fact reduce revenues either because individuals would work less rather than earn more and have it taxed away or because they would find ingenious ways of avoiding tax payments. In sum, any country which is to the right of the maximum would gain by reducing tax rates either because it would have the supply side effect of encouraging more work and output and therefore generating more taxes or would ensure greater tax compliance and therefore increase tax revenues.

In practice a whole host of factors including a nation’s per capita income, the extent of income inequality, perceptions of what the government does with tax revenues, the nature and efficacy of the tax administration and the justice implicit in the tax system go to determine the revenue (relative to GDP) generated by a given structure of taxes. This implies that what is the optimal maximum tax rate is impossible to specify, unless a lot of variables are taken as given and their effects are presumed to be understood. Yet, sections of the rich who have always believed that any prevailing tax rate is too high have pushed this view consistently, even if not through the medium of a formal curve. Economists inclined to advance that view have also used the notion in various ways.

The idea of a curve with theoretical and empirical substance gained currency during the Reaganite years of indiscriminate tax cuts, with the idea reportedly attributed by Wall Street Journal correspondent Jude Wanniski to Arthur Laffer, a subsequent member of Reagan’s Economic Policy Advisory Board, who is supposed to have drawn the curve for her education on a napkin. Popularity, of course, invites attention. And innumerable economists have spent time and energy to show that the concept is theoretically hollow and empirically unsubstantiated. This seems to have influenced even the US Congress with the US Congressional Budget Office questioning it validity in a 2005 paper.

But given the interest behind promoting the idea and the support of influential media of the kind that the Wall Street Journal represents, the idea has just not gone away. Since the rise of the Laffer curve idea in the 1970s taxes have been cut many times over across the world. Yet it is routinely invoked to justify further cuts in taxes. The point is that even today influential newspapers like the Wall Street Journal promote the idea, based on obviously mistaken reasoning.

Consider for example a recent report in the Wall Street Journal titled “We’re Number One, Alas” (13 July, 2007). Lamenting that the US is not among the 25 developed nations that have opted for “Reaganite corporate tax cuts” since 2001, the newspaper provides two reasons why the US government should follow the path adopted by these countries and others such as Vietnam. First, it makes the country a more attractive site for foreign investment. This, however, is unlikely to attract a country which without much effort draws on the world’s capital to finance its huge trade and current account deficit. But there is a second reason, according to the Journal: “Lower corporate tax rates with fewer loopholes can lead to more, not less, tax revenue from business. … Tax receipts tend to fall below their optimum potential when corporate tax rates are so high that they lead to the creation of loopholes and the incentive to move income to countries with a lower tax rate.”

Note the subtle shift in argument. Reduce corporate tax rates to prevent incomes from moving out of the country in search of relative tax havens. So you have to reduce tax rates either to attract FDI or to prevent capital flight of a kind. If every country begins to do this, the race to the bottom can take corporate tax rates to near zero. The call is not for international agreements that prevent such tax evasion, but to reduce taxes on fat corporate profits in a world where intra-country inequality is clearly rising. What is shocking is that this line of reasoning is backed up with the accompanying graph that ostensibly delivers a smooth Laffer-type curve from cross-country data. To any student with simple, school-level graphing skills it should be clear that using the low tax UAE and a median-tax outlier like Norway to draw the curve is a basic error, since all other points do not match its trajectory.

Yet using that graph the Journal approvingly quotes an “expert”, Kevin Hassett, an economist at the American Enterprise Institute whose view as expected is that the U.S. "appears to be a nation on the wrong side of the Laffer Curve: We could collect more revenues with a lower corporate tax rate."

Arguments of this kind abound in India as well, with the Finance Minister often providing support for such views. It needs to be noted that, despite having a scheduled corporate tax rate that is higher than in many countries, the effective tax rate for the private corporate sector in India continues to be low due to myriad exemptions. This led to the emergence of highly profitable zero tax companies, and has necessitated periodic recourse to a minimum alternate tax. In such a situation, to invoke the FDI flight bogey to cut corporate tax rates is merely to find an excuse to use fiscal policy to engineer a shift in income distribution in favour of the rich.
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